It might seem odd that Securities Acts written in 1933 and 1934 could be applied to the latest computer technology. However, laws written by our forefathers to protect the public are often still highly applicable today. Perhaps the lesson to be learned is that even though technology changes, human nature doesn’t, and the public must be warned of the dangers before hopping on the latest bandwagon in hopes of striking it rich.
Toward that end, in mid 2017, the SEC issued a Report of Investigation relating to “DAO Entities” (Decentralized Autonomous Organizations), i.e., those “using a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain” – commonly known as Cryptocurrency. The report was written in response to activities by Slock.It UG, a German corporation and its co-founders who sold DAO Tokens in exchange for Ethereum (ETH, another Cryptocurrency), which would be used to fund projects that were meant to generate a profit for the token holders. As a return on investment, the token holders would receive their returns in the form of DAO Tokens. The DAO Token holders could then sell their DAO Tokens in exchange for cash on web-based secondary trading platforms.
Details of the SEC Report of Investigation
In its report, the SEC found that:
- DAO Tokens are Securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).
- Advised those who would use a DAO Entity, or other distributed ledger or blockchain-enabled means for capital raising, that they must comply with U.S. federal Securities laws.
- Reminded issuers that all such tokens offered and sold in the U.S. must be registered with the SEC or qualify for an exemption from registration per Section 5 of the Securities Act.
- And further, that any entity or person engaging in the activities of a Securities exchange must register as a national Securities exchange or operate pursuant to an exemption from such registration per Section 5 of the Exchange Act.
The offer of sale of DAO Tokens are typically known as Initial Coin Offerings (ICOs) or Token Sales. In its analysis, the SEC applied the good old Howey Test to determine whether such offers or sales amounted to “Investment Contracts,” which is a term included in the federal (and state) definitions of Securities (see 15 U.S.C. §§ 77b-77c).
The four-prong Howey Test originated from a U.S. Supreme Court case decided in 1946 in which Investment Contracts were defined as: 1) an investment of money; 2) in a common enterprise, 3) with an expectation of profits; 4) based on the managerial efforts of others. – SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
Further, the SEC opined that an “investment of money” doesn’t have to be in cash to meet the first “prong” of the Howey Test, but that other forms of investment could create an investment contract, such as an exchange of goods or services or other things of value.
In the subject case on which the SEC’s Investigation Report was based, a DAO offered and sold DAO Tokens in exchange for Ethereum (“ETH”, another Cryptocurrency) through the DAO’s website. After being offered from the DAO Entity’s website, approximately 1.15 billion DAO Tokens were sold in exchange for approximately 12 million ETH, valued at approximately $150 million!!!
Guess What? Cryptocurrency is a Security! Best to Seek Expert Counsel on ICOs
What does this mean for you? In a nutshell, Cryptocurrency tokens are Securities, and all Issuers and exchangers of such tokens must comply with Securities laws or qualify for an exemption from registration. So, if you are contemplating an ICO, you need to seek guidance from a Securities attorney. (We can help.)
Securities counsel can help you register your offering or qualify for an exemption from registration, such as Regulation D, Rule 506(b) or 506(c), and further help you structure your offering so that you don’t run afoul of Exchange Act rules. For more on the particulars of each exemption, read our article entitled “506(b) or 506(c)—That is the Question.” Or, if you are ready to talk to an attorney about this or any other contemplated securities offering, click here to book a free teleconference with a Syndication Attorneys, PLLC attorney experienced in Securities offerings. For immediate assistance or to coordinate a different time, please contact Charlene Standridge at Charlene@SyndicationAttorneys.com or call 904-414-6690.
